LONDON, Oct 24 (Reuters) - Euro zone money market investors
are betting the European Central Bank will offer banks new
long-term loans in 2014 to curb a surging euro and a potential
rise in short-term rates that could derail a nascent economic
recovery.

Business survey data released on Thursday showing activity
in the region's services sector unexpectedly slowed in October
highlighted the fragility of the recovery in the euro bloc,
fostering expectations the ECB will loosen policy further.

ECB President Mario Draghi has signalled the bank will ease
if needed but recent comments by some of his colleagues have
cast doubt on whether this will involve fresh stimulus like the
1 trillion euros in low-cost three-year loans (LTROs) it offered
banks in 2010 and 2011.

Money markets are pricing in the possibility of a further
rate cut or another LTRO with participants leaning more towards
the latter as it has proven more effective in bringing down
lending rates more broadly than a rate cut. A rate cut would
also would not help interbank lending and so still leave weaker
banks out in the cold and reliant on ECB largesse.

Overnight bank lending rates, as measured by one-month Eonia
forward contracts, remain well below the ECB's 0.5 percent
refinancing rate until late 2015. The rates would move above the
ECB's main rate if the market starts pricing in tighter monetary
and liquidity conditions.

A further easing in ECB policy would drive money market
rates lower, making the euro less attractive for investors.

The single currency is at its strongest against the
dollar in two years and threatening to choke export growth.

"The market is gradually positioning for the potential for
the ECB to take another policy measure via a new LTRO during the
course of next year," said Patrick Jacq, a strategist at BNP
Paribas.

"This has probably been reinforced by the evolution of the
euro/dollar which has strengthened very significantly and could
cause some concern as far as the economic recovery is
concerned."

Draghi said earlier this month the ECB was "attentive" to
developments in the euro exchange rate even though it is not
among the bank's formal targets.

The euro rose above $1.3800 for the first time since
November 2011 on Thursday as the dollar remained under pressure
due to expectations the Federal Reserve will delay tapering
stimulus until next year. It has risen 4.7 percent against the
dollar and 5.3 percent versus sterling so far this year.

Companies in the region are already feeling the pinch as the
euro's trade-weighted index - reflecting its
strength against a raft of other currencies - hit its highest in
nearly two years.

Anglo-Dutch company Unilever Plc reported
slower sales growth after demand for its consumer goods was hit
by the devaluation of a handful of emerging market currencies.

German business software company Software AG
warned with its results on Thursday that its profits could be
hit if the euro stayed strong while Italian cable maker Prysmian
said the strong euro was not helping.

APPROPRIATE TOOL

A sharp fall in inflation could also give the ECB reason to
act next year, analysts said. At 1.1 percent in September,
inflation has fallen way below the ECB's close-to-2-percent
target.

"Although the ECB doesn't target the exchange rate, this low
level of inflation and further strengthening (of the currency)
could be an argument for a rate cut," said Anatoli Annenkov, a
senior European economist and ECB watcher at Societe Generale.

"But we still think that an LTRO is the more appropriate
tool because on the one hand it could support a weaker currency
and lower inflation while providing a liquidity backstop for
next year."

Money market rates may come under further upward pressure,
and the ECB under pressure to act, as excess cash in the euro
system is squeezed as banks repay earlier ECB loans. Rates
usually start to rise once excess liquidity - the
amount of money in the banking system above what it needs to
function - drops beneath 200 billion euros.

It stands at 187 billion euros, its lowest since late 2011,
just before the ECB flooded markets with 1 trillion euros via
LTROs.

"It's just a matter of time in the next few months ... we'll
start to have more upside pressure on Eonia. That's something
that the ECB doesn't want to see and could be a driver to push
the ECB to deliver another round of LTROs," said ING strategist
Alessandro Giansanti.

Datafeed and UK data supplied by NBTrader and Digital Look.
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